What sanctions are necessary?

a criminal offence carrying a maximum penalty of two years’ imprisonment and/or a fine. Individual deterrence and general deterrence are relevant factors taken into account when determining the period of disqualification.

It is public protection, even more than deterrence, that goes to the heart of the need for Disqualification Orders. Given that it is rare for directors to be imprisoned for breaches of the Companies Acts or FSMA, it could be argued that fines alone are not sufficient to deter future serious misfeasance by others and, more importantly perhaps, the individual concerned in the particular breach. The Disqualification Act should add vital weight to the regime by allowing the public to be protected in the future, something which neither fines nor reputational damage can necessarily do.

Is disqualification an effective sanction in practice? In day-to-day business it is very unlikely that directors will think about, much less worry about, disqualification. Of some 1300 disqualifications in 2004/5, over 1100 of them were made following insolvency.31 It seems that it is only when companies have reached their end game that disqualification on the grounds of unfitness really has a part to play. For this reason, disqualification does not appear in the Virtuous Circle.

The sanctions: the role of the Courts

The growing significance of the Courts

Directors who get it wrong may be subject to common law civil claims for breach of duty, tort (negligence or deceit), breach of trust and fraud. In practice, the most common claims are for breach of duty and the sanctions available under these claims are considered in this section.

Cases such as Foss v. Harbottle32 have long established that a director owes his common law duties to the company and that it is the company which may bring any claims against him for a breach.

However, in exceptional circumstances, claims against directors for breach of duty can be brought by shareholders. These derivative claims, in fact, are actions brought by shareholders to enforce causes of action vested in the company rather than actions by shareholders in their own right. The case law establishes that, in the main, derivative claims can be brought only where the breach of duty constitutes a fraud or abuse of power to the benefit of the wrongdoers and the wrongdoers are in control of the company (such that a direct claim by the company cannot be brought in practice).

For some time, there have been concerns that derivative claims are not an effective remedy for wronged shareholders, on the basis that the principles governing such claims are defective in some aspects and uncertain in others.

31DTI Report, Companies in 2004–5, published October 2005.

32(1843) 2 Hare 461.

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More recently, calls for a clearer statement of the law on derivative claims have increased while, at the same time, a string of high-profile breach of duty cases has fixed public attention on the circumstances in which directors should be brought to book for their actions. Against this background, the 2006 Act includes new provisions which clarify and extend the availability of derivative claims, and it is these provisions which merit such claims being included in the Virtuous Circle.

The 2006 Act endorses the Foss v. Harbottle principle while introducing a statutory basis for bringing shareholder claims against directors that replace the common law principles. Under the 2006 Act, a shareholder may bring a derivative claim against a director for breach of trust, negligence and breach of duty. However, the Courts have a general discretion to allow or prevent such a claim from proceeding at an early stage.

Consequences of breach of duty

The main potential consequences for a director who is guilty of a breach of duty are as follows:

He can be personally liable to account to the company for any net financial benefits he has received as a result of the breach of duty, and such liability is unlimited. Financial benefits received by a director can be traced where, as a result of the breach of duty, they are held on constructive trust, and a director’s assets may be frozen to assist in this. In certain cases, compound interest can be ordered to be paid on the relevant sums.

He can be personally liable in damages for the net loss which the company suffers as a result of the breach of duty, and such liability is also unlimited. The measure of loss is usually related to restitution, so that the company is put back in the position it would have been in if the breach had not occurred.

Actions taken by directors, such as an issue of shares, or arrangements made by them, such as entering into a contract on behalf of the company in breach of duty, may be declared void.

If the director is an employee of the company, and the breach of duty involves some element of extreme behaviour, such as dishonesty, he can be summarily dismissed without compensation. In addition, shareholders can choose to take this action under the Companies Acts if directors choose not to.

Actions giving rise to a breach of duty at common law often constitute specific statutory offences (particularly under the Companies Acts) involving criminal liability for the director, resulting in fines or imprisonment.

In respect of potential or ongoing breaches of duty, it is open to a company to apply for an injunction, for example where customers of one company are being diverted to another which is owned by a director, and the director has brought the jurisdiction of the Disqualification Act into play.

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What sanctions are necessary?

The position of non-executive directors

Non-executive directors cannot necessarily claim a reduced level of duty or liability compared to executive directors. Again, it may be that there is some mitigation arising from their position, depending on the circumstances, but the comments of the Court in the Equitable Life33 case emphasise that there is no general principle that a non-executive director should be treated any differently from his executive counterparts.

Protecting directors

The liability of a director for breach of duty may be the subject of an indemnity from the company and/or directors’ and officers’ insurance. Rules introduced in April 200534 extended the range of matters for which a director may be indemnified but, critically, a director cannot be covered for liability owed to the company itself. D & O insurance is, of course, commonplace (for listed companies it is expected under the Combined Code), but liability to the company is routinely excluded and, even where it is not, limitations apply.

Before the issue of personal liability rose up the corporate agenda, directors were often content not to have specific indemnities in place, but to rely on companies invoking a specific power to do so in their articles of association in the unlikely event this was necessary. However, given that indemnity provisions in articles of association are only commitments between the company and its members, it is possible that a director may not be able to invoke such an indemnity as and when he needs to. As a result, it is increasingly common to see stand-alone deeds of indemnity being put in place between companies and directors to give directors a right to indemnification.

The impact of the 2006 Act

The 2006 Act expressly confirms that the existing civil remedies for breach of directors’ duties will continue to apply in respect of the codified duties. It is not clear how this will operate in practice in respect of those elements of the codified duties which are additional to or different from the existing common law duties. However, given the range and flexibility of the existing sanctions, it is suggested that greater difficulties will be met in assessing whether a director has breached the new codified duties than in assessing the nature of the sanctions which should be imposed if a breach is proved.

The new statutory basis for derivative claims has been the subject of much debate. While the principle of opening up a clearer route for shareholders to bring directors to account for their actions is generally applauded, concerns have been expressed in Parliament and, subsequently, by industry bodies, such

33[2003] EWHC 2263.

34Pursuant to the C(A,ICE) Act which amended the 1985 Act – see ss. 309A et seq.

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as the Institute of Directors and the CBI, that the provisions of the 2006 Act will result in:

derivative claims with low merits or malicious claims being brought to the detriment of the company and the shareholders as a whole;

activist shareholders bringing derivative claims to achieve other purposes, such as to hamper takeovers or to pursue their own financial agenda.

Against this, it is argued that:

under the 2006 Act, a claimant shareholder will be responsible for the costs of bringing an action, while any financial award resulting from a successful action will accrue to the company (this same situation applies to existing derivative claims at common law). This will operate to deter shareholders from bringing derivative claims unless they are merited;

the Courts have a discretion to deny any derivative claim from proceeding and, in fact, the 2006 Act directs the Courts to refuse permission to bring a claim in certain circumstances (such as where the shareholder is considered to be acting in bad faith or a hypothetically impartial director would consider that continuing such a claim would not promote the success of the company).

It is likely that the new law will result in an increased number of claims being brought against directors. The overall impact may be to provide shareholders with improved access to the Courts in appropriate cases (and, in doing so, assist in the application of effective corporate governance), but there is a real danger that it may equally open the door to spurious claims that could not have been brought under the existing common law. The responsibility for what happens next lies with the Courts, and their decisions as to which cases are allowed to proceed and those which are refused will be keenly watched.

Adequacy of civil sanctions for breach of duty

It is generally accepted that a range of flexible and meaningful sanctions must be in place to deal adequately with the consequences of breaches of duty by directors. The question is whether the existing common law and the 2006 Act provide those sanctions.

Some would argue that the steady flow of actions against directors, many of them in respect of high-profile company failures, demonstrates that current sanctions are not sufficient to deter directors from engaging in bad governance or illegal practices. By contrast, others would argue that the increasing number of actions being taken against directors is not due to their being ignorant of, or complacent about, their duties, but is rather a consequence of the prevalent blame culture. And yet others might argue that the cases show a welcome increase in the policing of boardroom behaviour.

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